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Explain strategic asset allocation and how a portfolio is rebalanced

CFA® Level I · Portfolio Construction · Basics of Portfolio Planning and Construction · PM.3.d

The idea

Strategic asset allocation translates objectives and constraints into long-term target weights for asset classes, and is the decision that explains most of the variation in a portfolio's returns over time. Because asset classes grow at different rates, actual weights drift away from targets, raising exposure to whatever has performed best - often just as it has become more expensive. Rebalancing restores the targets, either on a calendar schedule or when a weight breaches a tolerance band. It is contrarian by construction, which is why it is psychologically difficult and why the policy should be written down in advance.

Formulas

Weight after drift

weight now = value now ÷ total portfolio value

value now
the holding's start value grown by its return
total portfolio value
the sum of every holding's current value

Assets that earn more grow into a larger share. Rebalancing sells the winners to restore the target weights, by calendar, by percentage band, or by a mix of the two.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does strategic asset allocation set?

  1. The list of individual securities to holdWhy not: Security selection happens inside each asset class, after the allocation has been decided.
  2. Long-term target weights for asset classes - correct
  3. The timing of purchases within a quarterWhy not: An execution matter. Strategic allocation is about long-term weights, not when orders are placed.

An asset class is a broad group of investments, such as shares, bonds or property. Strategic asset allocation is the long-term plan for how much to hold in each class, for example 60% shares and 40% bonds. It sets the target weights, and it is meant to stay in place for years. Choosing individual securities happens afterwards within each class, and short-term shifts away from the targets are called tactical. It is not about when individual orders are placed.

A harder one

Why is rebalancing described as inherently contrarian?

  1. Because it requires selling what has risen and buying what has fallen - correct
  2. Because it requires buying the assets that have recently performed bestWhy not: That is momentum chasing. Rebalancing does the reverse, trimming the winners and adding to the laggards.
  3. Because it is triggered only when investors expect a market fallWhy not: Rebalancing is triggered by a schedule or by weights drifting past bands, not by market forecasts.

Rebalancing means returning a portfolio to its target weights after prices have moved it away. Contrarian means going against the crowd. Assets that rose now take up more than their target share, so you sell some. Assets that fell take up less, so you buy more. Trade = Target weight x Portfolio value - Current value of the asset. This feels uncomfortable, since you sell what is doing well and buy what is doing badly. That is why a written rule helps. It is done on a schedule or when weights drift too far, in any market.

The hardest tier

What risk does an un-rebalanced portfolio accumulate over a long bull market in equities?

  1. Excessive cash holdingsWhy not: When equities rise, the weight of cash and bonds shrinks, so the drift runs the other way.
  2. Loss of exposure to the best-performing assetWhy not: Without rebalancing the winner's weight grows, which is exactly the problem: the exposure increases rather than lapses.
  3. A rising equity weight - correct

When shares rise faster than other holdings and you do nothing, shares become a bigger slice of the portfolio. Equity weight = Value of equities / Total portfolio value. Example: start with 60 in equities and 40 in bonds. Equities double to 120 and bonds gain 10% to 44. The total is 164, so the equity weight is 120 / 164 = about 73%. The portfolio has quietly become much riskier than the 60/40 plan, and the investor may only notice after a fall.

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